Municipal Bonds And ESG: All Hat, No Cattle

Houston, we have an ESG problem. Or do we?

From an ESG-risk perspective, between the weather and petroleum-dependent economy, the City of Houston, Texas would appear to have some major problems. Of the two, the weather has been the most visible.

For Houston, on Galveston Bay off the Gulf of Mexico, geography is destiny. The city gets hit regularly by tropical storms. According to NOAA’s National Centers for Environmental Information, there were 96 days with at least one report of flooding or flash flooding in Harris County from 1996 through 2015. This equates to an average of four to five days of flooding each year over that time period.

It’s been this way for the city since day one. Founded in 1836 by the Allen brothers, the town was established at the confluence of Buffalo and White Oak bayous. Shortly thereafter, every structure in the new settlement flooded. The issue hasn’t changed much since.

Recently, storm-related flooding only seems to be increasing in frequency and intensity. Since 2015 alone, Houston has been hit by six named hurricanes and tropical storms. One of the worst was Hurricane Harvey. Hitting in 2017, the storm was estimated to have caused over $70 billion in damages, although some have the number far higher.

Of Bonds and Hurricanes

On September 10, 2019, Houston finalized a $255.3 million tax-exempt bond issue secured by a pledge of ad valorem property taxes. The largest series was the $35.62 million 2030 maturity, priced with a 5.00% coupon at an initial yield of 1.59% ($129.883). According to data from IHS MarkitINFO
, the AAA-10-year tax-exempt yield was 1.35% the day the bonds were priced. The yield difference between the two is referred to as the credit risk spread, in this case, 24 basis points. A basis point is 1/100^th of 1%.

On September 17, 2019, Tropical Storm Imelda hit, producing historic rainfall totals of more than 40 inches over the next 48 hours, causing devastating flooding to Houston and other areas of southeastern Texas. Like Hurricane Harvey, it caused billions of dollars in damages.

With all this expensive environmentally driven damage, how did investors respond? To gauge investor reaction, we can look to the Municipal Securities Rulemaking Board’s EMMA trade data to see at what prices bonds traded. Using trades on the 10-year 2030 maturity bonds (ten-year bonds are a market standard), from September 18^th to the 24^th, $66 million in debt moved between investors in 12 trades over four days. While the bonds were issued at $129.883 (1.59%), the first trade was at $126.138 (1.95%). If you are wondering why the yield went up, keep in mind that a bond’s yield moves inversely to its dollar price.

Face Off

Buying bonds at $129.883 and then selling them at $126.138 is not a money-making proposition. On a $1 million trade, it’s a $37,450 loss. In the vernacular of the market, whoever sold bonds in that first trade got their face ripped off.

The reason for that initial sale is not known, but if it was based on Tropical Storm Imelda—the timing is a bit too close for just mere coincidence—it proved to be an expensive panicky mistake.

The last trade, at the end of the period, was 1.53% ($130.34). If the investor who bought those bonds from the panicky seller at 1.95% sold them those few days later at 1.53%, on a $1 million trade, they’d have made a tidy $42,010 profit in five business days.

ESG risk, ShmeeSG risk

About two years later, on August 31, 2021, Houston came to market again with a $188.36 million Series A tax-exempt bond issue, also secured by a pledge of ad valorem property taxes. The 10-year bonds (maturity: 03/01/2031) in this issue were priced with a 5% coupon to yield 1.10% ($135.088). This interest rate was considerably better than the 2019 series, specifically 49 basis points better—1.10% versus 1.59%.

In fact, Houston’s GO bonds outperformed the market. The overall market rallied substantially since the prior 2019 bond issue. The yield on the IHS AAA 10-year was now at 0.93%. However, this 42-basis point improvement since September 10, 2019, did not keep pace with the 49-basis point rally of the bonds issued by the City of Houston.

And better still. Remember the credit risk spread between the bond issue and the market in 2019 was 24 basis points? By the time the 2021 bonds came to market, the spread tightened to 17 basis points.

ESG risk, ShmeeSG risk—the Houston bonds outperformed the market on every investment performance metric.

Muni ESG: All Hat, No Cattle?

Now drawing the conclusion that the muni market’s vocal admonitions as to ESG’s importance are all hat but no cattle based on just one city, a couple of bond issues, and a handful of trades wouldn’t be fair.

Equally, maybe it is also unfair to base an overall view of Houston’s ESG ranking on just one metric—damage from hurricanes and tropical storms. There is far more to ESG metrics than flooding, no matter how persistent.

Moreover, perhaps the market is actually getting it right, as markets so often do. After all, in 2021, the city received an “A” rating from the CDP, formerly known as the Carbon Disclosure Project. It was the first year the city was recognized by this top-drawer rating, joining 94 other cities on the A-list.

The CDP is no Johnny-come-lately organization. They have staked their claim as being a standard-setter since forming in 2000. This not-for-profit’s worldwide offices oversee the global disclosure system for investors, companies, cities, states, and regions to guide the management of their environmental impacts. Based on the standards set by CDP, some 10,000 companies and cities generate environmental disclosure reports on climate change, water security, and forests. Over 590 institutional investors representing some $110 trillion in assets use these reports in assessing environmental risk relative to returns. That sure supports their claim to be the world’s largest environmental disclosure organization.

The city of Houston notes that the CDP’s Cities A-List is based on environmental data disclosed by cities under the CDP unified reporting system. To score an A, a city must have and publicly disclose a city-wide emissions inventory, have a set emissions reduction target and a renewable energy target for the future and have published a climate action plan. A city must also complete a climate risk and vulnerability assessment and have a climate adaptation plan to demonstrate how it will tackle climate hazards.

Pretty evidence-based stuff. But before crediting Houston’s A-List CDP ESG disclosure rating for its above-market bond performance, keep in mind that over the 98 weeks between Houston’s first bond sale in September 2019 and its second bond sale in August 2021, over $185 billion dollars of investor funds came into the market, according to the Investment Company Institute. In fact, over the period, the market experienced 93 weeks of inflows and only 5 weeks of outflows, the latter totaling $4.3 billion. These inflows do not include funds that came in from separately managed accounts, or investment dollars of institutional investors other than mutual funds, such as insurance companies, which likely pushes the amount far higher.

Yes, Houston’s bonds outperformed the market, but that doesn’t mean we can draw the conclusion that the market-beating seven basis points are attributable to the “A” rating that CDP codified. Is Houston’s outperformance really a recognition of ESG progress? There is scant independent evidence to establish that seven basis points are really what the ESG disclosure rating is worth.

It is far more credible that investor fund flows and issuance/demand imbalance generated the additional performance.

Oh, not for nothing, the CDP rating came in November 2021—well after the 2021 bonds sold. Markets are good but rarely prescient.

My ESG Metrics are Bigger than Your ESG Metrics

There is another question: is the CDP rating really using the right ESG measures? While fastidious about certain environmental impacts, they wholly ignore other ESG factors. CDP disclosure categories and metrics are robust, yet there seems to be no financial accounting for the seemingly incessant flood risk from climate change.

John McLean, the head of Muni QualityScore at ISS, takes a more expansive ESG perspective. Drawing on extensive sets of data, some going back to 2009, ISS has quantifiable metrics covering everything affecting environmental, social, and governance factors in a community, from education to safe drinking water to health access to dams at risk of failure. In total, there are over 90 million data points used to establish a Muni QualityScore on over 27,000 cities and towns, 13,500 school districts, and 3,151 counties—all linked to the over 1.3 million CUSIP-identified bonds in the municipal bond market, down to specific locations.

With this arsenal of data, the ISS Muni QualityScore for Houston gets an overall “C”. The city’s Environmental score? A dismal “D”.

In Conclusion

All this may seem as clear as the mud after a hurricane caused floods in Houston because ESG is still nascent in the municipal bond market. Perhaps it hasn’t reached that tipping point just yet. These trades and, one suspects, many more like them across many other bonds, are only a point in time, not an indication as to how this will play out over time. As credit and risk assessments and subsequent investment decisions become more refined, it may prove that basis point differences will emerge to quantify ESG risks more accurately.

Oh, One More Thing

Final note. During this period, the credit rating agencies rated Houston’s outstanding general obligation bond debt as AA/Aa3 (S&PGlobal and Moody’s, respectively). These ratings remain unchanged today.

And why wouldn’t they be? For all the natural disasters and economic shifts Houston faces, particularly from the petroleum business (in 2019, nearly one in five dollars earned in Houston was paid by an energy-related firm), fundamentally the tax base and financial standing of the city are sound. There is no deterioration of creditworthiness.

Yet.